Moral Hazard – April 2008

April 17, 2008

Dow Jones Average: 12,619
S & P 500 Index: 1,365


Moral Hazard

The term “moral hazard” is sometimes used by government officialsa ddressing difficult choices in the wake of financial crises. It is the kind of obtuse language that slides easily from the lips of Federal Reserve Board chairmen, who always claim that Fed policies are NOT designed to create a moral hazard. This dense, puzzling term was not widely used until recent weeks when the Federal Government rescue of Bear Stearns made it profoundly relevant. Now the mainstream media, Presidential candidates, and financial commentators are all talking about moral hazard. So it’s time to shed some light on the meaning and implications of this somewhat sinister sounding term.

Moral hazard is a term that originated in the 1600’s. It was used by insurance companies of that era to describe possible changes in behavior on the part of those who bought insurance. The supposition was that people who acquired insurance might be less careful with the items that were insured, because any loss would be covered. This aspect of human nature concerned the insurance companies, as they did not want to pay for losses caused by careless, risky behavior. It was thought that the very act of providing insurance could create a hazard to moral behavior, hence the term “moral hazard”. Insurance companies in the 1600’s had the same concerns as insurance companies of today. Insurance companies have always worried about losses caused by the careless, immoral (meaning risky), and possibly fraudulent actions of their customers.

In more recent times the term “moral hazard” has been used to describe government policies that imply a guarantee against financial losses. When investors assume that financial losses will be limited or cushioned by government action (taxpayer bailouts), risk taking abounds. Investors as a group, from the small timer to the largest hedge fund managers, are encouraged to take on greater risks if they believe that the rewards could be huge, and the losses always minimized by a government rescue. Former Fed Chairman Alan Greenspan professed a concern about creating a moral hazard, but every time things got ugly in the markets he bailed out the high rollers who had taken on too much debt. With the government effectively on their side, the highest risk takers eventually came to dominate the markets.

We are now seeing the effects of asset concentration in the hands of careless, short sighted, greedy investors and financial institutions. The losses and the impact on society are staggering. The current mess is too big to be fully bailed out by the government. But Ben Bernanke, Greenspan’s successor, is trying, starting with the rescue of Bear Stearns. He cannot save all the financial institutions that are teetering. Nor should he try to save them all. The modern use of the term “moral hazard” has been divorced from the original focus on immorality and fraud. It is now used to describe a condition where risk taking is overly encouraged, because the investors believe that any losses will be mitigated, shared, insured, or passed onto some other party. It is assumed that investors are making good faith judgments and have simply miscalculated. I think that the original, 1600’s meaning of moral hazard is more accurate. If taking big risks, often with other people’s money, keeping the fortunes made from the good times, and then dumping the losses onto innocent parties such as taxpayers, isn’t immoral, what is?

Current Strategy

Equity markets throughout the world fell sharply in the first quarter of 2008. The Standard and Poor’s 500 Index, which is the most widely followed index in the U.S. lost more than nine percent during the quarter. Chaos in the credit markets, which culminated in the collapse of Bear Stearns, kept investors on edge throughout the quarter. While the financial stocks continued to collapse, the price of commodities went through the roof.

Investors are now facing the triple threat of inflation, recession, and a debt crisis. Respected economists are forecasting the worst recession since WW II. Debt in the U.S. is at a record level relative to the size of the economy. The steady decline in the value of the U.S. dollar is fueling inflation, particularly of imported commodities such as oil. The stock market has fallen in the U.S., but is really not down that much given the magnitude of the problems faced by the country.

Volatile, sharply declining markets produce opportunities for investors who have conserved their capital. We pounced on such an opportunity in late January, after three weeks of relentless, large declines in the stock market. We bought a number of stocks that had been unfairly beaten down in our opinion. The companies we purchased had no particular problems or worrisome exposure, and had simply been dragged down by the panic afflicting the troubled, financial stocks. Our buys were focused on the energy and technology sectors. All of the January purchases have worked out very well since. We hope that similar buying opportunities occur throughout the year as investors react to the serious economic threats overhanging the economy.

Investors continued to pour money into the safest, most liquid, fixed income investments (treasuries) during the quarter while shunning bonds that carry risk. Even highly rated municipal bonds fell in value during February and March, due to short term liquidity issues. With short term interest rates below the two percent level there is not much that one can do except sit tight with bonds bought in prior years. By driving interest rates to the two percent level, the Federal Reserve is once again exacting a significant penalty on savers and conservative investors. Investors should be wary of longer term bonds, because the Fed has abandoned any pretense of controlling inflation. With food, fuel, and medical inflation running high, there could be a swift rise in rates at the first sign of economic stabilization. Interest rates will track inflation rates over time. We are keeping large amounts of client assets in short term investments, awaiting a return to a more normal relationship between interest rates and inflation.

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